Bubble: It's Coming, but We're Not There Yet, Experts Say

San Francisco’s current reign as an international “super core” target for real estate investors will continue for two or three more years, but already there are warning signs of a bubble market.

That is the consensus of a panel of San Francisco real estate executives made up of Swig President and CEO Jeanne Myerson, BRE Properties CEO Connie Moore, and economist Ken Rosen. The three spoke at a panel entitled "Real Estate Bubble? Near-term Opportunities and Challenges in Bay Area Real Estate" sponsored by Financial Women of San Francisco. It was moderated by Julia Wilhelm, a managing director with Studley, a commercial real estate brokerage.

Myerson recounted a recent bid her company made on a property in downtown Palo Alto, across from the Caltrain Station. Swig’s offer came in at a whopping $1,000 a square foot, and had the additional incentives of a quick close, no contingencies, and a willingness to offer up a property for a tax deferred exchange. Despite the exorbitant offer, Swig was not one of the finalists.

“We weren’t even at the table,” said Myerson. “There is capital flight going on where everybody wants the same thing. Talking to people who bid on the property, they are projecting continued strong growth in rents. We are not."

A lot of buildings in the Bay Area's elite markets these days are trading for "silly" numbers, Myerson said. Every institutional Investor seems to be targeting the top three Bay Area markets -- San Francisco, Mountain View, and Palo Alto. But they are also expecting double-digit returns. "That is not going to happen in this market when you are buying largely leased stuff at a very high basis," she said.

Along with the energy-fueled Texas markets of Dallas, Houston, and Austin, San Francisco and San Jose are the most robust economies in the country, according to Rosen. San Francisco added 41,000 jobs in 2012 and 18,000 jobs so far this year.

Rosen, chairman of the Fisher Center for Real Estate and Urban Economics at UC Berkeley, said a lot is going right for the Bay Area this time around. In contrast to the boom of 1999 and 2000, San Francisco tech companies are profitable and are not taking large amounts of “shadow space” to accommodate unrealistic future growth. Still, he said the valuations of some Bay Area tech companies preparing to go public are crazy. “We have to worry about that,” he said. “We have all these companies that certainly have lots of revenue, they are making profits, but should they be (valued at) 1000 times income? I don’t think so.”

Rosen also said investors should be wary of buying buildings above replacement costs, something that has been happening in the South of Market. In the past few weeks several SoMa buildings have sold for between $600 a square foot and $650 a square foot. While you could argue that historic brick and timber SoMa buildings are irreplaceable, those prices are slightly higher than what it would cost to build a contemporary tech-friendly structure that would be competitive with the vintage ones.

“I would be very careful of buying anything above what it costs to build,” said Rosen. “It makes me uncomfortable that we are seeing that again in San Francisco. It’s a mistake. You can’t rely on interest rates staying low forever. There is no question in my mind that by 2017 we will have moved back to a 4 or 5 percent treasury bond. Maybe it won’t happen as quickly as I think, maybe it will happen sooner. So if you are buying something based on 2.6 treasury, it’s a mistake. You have to look at replacement costs.”

Moore, whose company BRE is constructing 360 units in two buildings in Mission Bay, said she is confident that demand is strong enough to absorb the units. But there will be soft patches along the way as inventory floods the marketplace. BRE’s project will open about six months after UDR opens its 315-unit development at 185 Channel St., and Equity Residential is not far behind BRE with a 257 units development.

“There has been such a lack of supply in the Bay Area, it’s been great to be a landlord,” said Moore. “Long term it’s going to be a great market, but there are going to be a lot of concessions for all of this new stuff. Most of the stuff that we have under construction, the rents that we see today are clearly higher than what we thought they would be at this point when we underwrote the transactions. But the flip side of all the supply you are seeing in Mission Bay is that at some point that is going to weaken revenue growth. Ultimately rent growth has to track wage growth.“